In the Foreign Exchange Market (Forex) you buy one currency while simultaneously selling another currency. That is why currency exchange rates are always quoted in pairs. For example: GBP/USD (British pounds/U.S. dollars). Okay, that sounds simple enough; but how does it actually work?
When you buy or sell a currency, your expectation is that the price of the currency you bought will increase in value (appreciate) in relation to the currency you sold or, conversely, if you sell a currency, your expectation is that the price of the currency you sold will decrease in value (depreciate).
Currency Pairs: Again, currency rates are quoted in pairs because in every foreign exchange transaction one currency is bought while another is sold. It is a simultaneous transaction.
The currency listed to the left of the slash ("/") is known as the base currency and the currency listed to the right of the slash ("/") is called the counter or quote currency. For example, with the GBP/USD currency pair, GBP is the base currency and USD is the counter or quote currency.
Exchange Rates: An exchange rate is the ratio of the value of one currency compared to the value of another currency. For example, the GBP/USD exchange rate indicates the value of British pounds compared to U.S. dollars and U.S. dollars compared to British pounds.
Example exchange rate: GBP/USD = 1.3900 tells us that it would cost 1.3900 U.S. dollars to buy 1 British pound. Also, if you wanted to sell 1 British pound, you would receive 1.3900 U.S. dollars on the sale.
So you see, the base currency is the "basis" for either a buy or a sell transaction.
If you buy EUR/USD this means that you are buying the base currency and simultaneously selling the quote currency.
Further, you buy the pair when you think the base currency will increase in value (appreciate) relative to the quote currency and,
conversely, you sell the pair when you think the base currency will decrease in value (depreciate) relative to the quote currency.
NOTE: In the above scenarios, if you buy a pair you go "long" and if you sell a pair you go "short." Transaction Example
You buy 10,000 Euros at the EUR/USD exchange rate of 1.29
It costs you 12,900 U.S. dollars. (Much less out-of-pocket with a margin account.)
If the Euro appreciates to 1.39 (GBP/USD = 1.3900) against the U.S. dollar and you decide to exchange the Euros you bought, back into U.S. dollars, you would receive 13,900 U.S. dollars in the transaction for a profit of 1,000 U.S. dollars. (13,900 you received in the sale minus 12,900 you paid when you bought the Euros.)
Once again, you buy a pair (go long) when you think the base currency (the first one in the pair) will appreciate and you sell a pair (go short) when you think the base currency will depreciate.
Bid/Ask Spread:
There are two prices in all FOREX quotes-the "bid" and the "ask."
The bid is always lower than the ask.
The bid is the price at which the dealer is willing to buy the base currency in exchange for the quote currency. Thus, the bid is the price at which you (the trader) can sell.
The ask is the price at which the dealer will sell the base currency in exchange for the quote currency. Thus, the ask is the price at which you can buy.
The difference between the bid and the ask price is known as the "spread."
GBP/USD Price Quote Example
1. The bid price is 1.3950 and the ask price is 1.3954. 2. To buy GBP, you click "Buy" and you will have bought British pounds at 1.3954. 3. To sell GBP, you click "Sell" and you will have sold British pounds at 1.3950.
To Buy Or To Sell, That Is The Question!
We list many Courses and eBooks on this website that can help you learn whether to buy or sell and when to do either one. You will also find trading systems and trading software here that can tell you if and when it is a good idea to make a trade. Meanwhile, here are a couple of very simple examples of how you might go about making these decisions.
Example 1:
EUR/USD (Euro is the base currency and thus the "basis" for the buy/sell.)
You expect the U.S. economy will continue to weaken, and that the Euro will appreciate against the U.S. dollar, so you decide to execute a Buy EUR/USD order. If you expect the opposite to happen, you would, logically, decide to execute a Sell EUR/USD order.
Example 2:
USD/JPY (USD is the base currency and thus the "basis" for the buy/sell.)
Because you have been watching the world economic news, you believe that the Japanese Yen is going to weaken (depreciate) against the U.S. dollar. Therefore, you decide to buy the USD/JPY pair in the expectation that the U.S. dollar will appreciate against the Yen. But if you see a different scenario in which you believe the Yen will strengthen against the dollar, you would, logically, decide to sell the pair.
IMPORTANT NOTE: Good Forex brokers simplify all of this and make your trading as streamlined as possible with user-friendly trading platforms.
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